One market indicator that might be off your radar is mutual fund flows. We can get an idea of what the public’s asset allocation looks like by how much cash, equity, or bonds the professional mutual fund manager has in addition to how much money John Q. Public is investing into funds. It’s typically the retail investor and pension fund managers that use mutual funds. So by following fund flows, we can get an idea of where John Q Public is investing. The easy place to find this data is free, at the Investment Company Institute.
One of the latest trends we can glean from the data provided by ICI, is that low interest rates are driving investors out of money market funds and into bonds. What’s more important to us this far into this trend is that it hasn’t been broken. How can one tell that investors are continuing to flock into bonds? Well, there are two steps to identify the trend: 1) money is leaving money market funds, and 2) bonds are receiving a net inflow while equities are experiencing net outflows. Here is the total net assets chart for money market funds:
Notice the decline since early 2009?
Source: www.ICI.org
A growing money market fund asset base in 2007 was a surprising warning to equity and bond investors. Since early 2009, cash has been leaving money market funds in search of a better return elsewhere. If cash is leaving money markets, where did it go? Into equity mutual funds; or how about bond funds?
Source: www.ICI.org
Source: www.ICI.org
So both equities and bonds have had net inflows over the past year and a half, but if you look at just the net inflows instead of total assets, you find that money has been continuing to pour into bonds at a greater (and steadier) rate than in stocks.
Source: www.ICI.org
It’s clear to me that in May 2010 we had a bit of deleveraging as both bond and equity funds saw net outflows. Equity net inflows haven’t been positive since April 2010. You mean not even in July when the S&P 500 climbed 10%? Well, foreign equity mutual funds have experienced some inflows, but domestic equity mutual fund outflows have skewed the results for the total.
On a monthly basis, bond net inflows have been positive since April 2009 with only one down month, in May 2010. Since May bond inflows have picked up again. This might be why corporate bonds haven’t dropped this month like they did in May.
Overall, money market funds have been experiencing net outflows since early 2009. This is beneficial for both equity and bond funds, but the evidence points that money is continually pouring into bonds.
We can also look at fund flow data to judge whether a sector has been fully played through. From a contrarian prospective, the public gets the trend right the majority of the time according to one of the founders of contrarian thinking, Humphrey Neil. It’s only at tops and bottoms that they get it wrong. John Schultz once wrote in a Barron’s article before the 1987 crash on the subject:
"The guiding light of investment contrarianism is not that the majority view—the conventional, or received wisdom—is always wrong. Rather it’s that the majority opinion tends to solidify into a dogma while its basic premises begin to lose their original validity and so become progressively more mis-priced in the marketplace"
So the idea now is to identify what the premises have been for investors to invest in bonds over stocks. Let’s name some of the bond premises for being in bonds:
- The interest rate spread between short and long term yields.
- Fear of deflation or contracting economy.
- Falling interest rates.
- Too much risk in equities.
- Quantitative easing.
Yield Curve
With a short-term yield below half a percent, long-term yields have looked attractive to investors looking for safer income than in equities; however, does a 10-year Treasury Note currently paying 2.6%— as opposed to 4%— look safe? I don’t think so.
Fear of deflation or contracting economy
Economic indicators have definitely rolled over recently. Unemployment claims have broken out to a new recent high, sales have declined, and manufacturing is slowing after the first half of the year spent restocking inventories. There’s no arguing with the cave bears at this point; however, there’s a reason foreign central banks are already raising interest rates. When one bubble deflates like it did with U.S. housing prices, money finds another bubble to inflate. That bubble could well be bonds with massive retail investor inflows.
Falling Interest Rates
Are interest rates going to fall much further? Take a look at this chart and you tell me. You don’t need a chartered market technician certification to say this looks like a 30-year bottom in interest rates. Although a base hasn’t formed in interest rates, the decline sure looks long in the tooth.
Source: “Irrational Exuberance” by Robert Shiller
Too Much Risk in Equities
Richard Russell recently called for a Dow Theory "Buy Signal" but he hasn’t purchased stocks. Why? Because he believes P/E ratios are high. They were lower last year, but investors have buoyed stock prices in anticipation that earnings will rebound. The second quarter earnings season showed us that earnings have come back, but most of that was from cost cutting. Looking back at the chart above, I can see why many would agree with Russell when previous bear markets have bottomed in single-digit P/E ratios.
Quantitative Easing
I talked about quantitative easing two weeks ago before the FOMC meeting. The premise now is that the Federal Reserve Bank will increase their balance sheet and buy U.S. Treasuries to keep rates low. I certainly wouldn’t want to be fighting the Fed. They have more monopoly dollars than we do.
The Fed is slow to act and will likely take baby steps to add more stimulus to the economy. As of yet, all we’ve seen is a growth slowdown. They’re likely waiting to see if the unemployment rate starts to rise again or if manufacturing does, in fact, show contraction conditions instead of deceleration.
Summary
Mutual fund flows show that cash is leaving money market funds and going into bonds. Despite the July rally in the equity market, fund flows have been negative for equities since May. Going contrarian now against bonds is a gamble because some of the premises for owning bonds still look to be on solid ground. Even though interest rates are at record lows, a catalyst to reverse the secular trend has been lacking for some time.
This is, however, a macro play that all investors should be checking into on a regular basis. If Pimco is hiring equity specialist staff and the “bond king” Bill Gross is talking about why he likes stocks on the cover of Bloomberg magazine, maybe they see the writing on the wall too.
